[Expert Corner] Due Diligence: Need and Benefits by Anshul Ramesh and Avesh Harshan- PART-II | Corp Comm Legal on Corporate Law

Part II – Need and Benefits of Due Diligence 
by Anshul Ramesh and Avesh Harshan
Now let us dive into the needs and merits of Due Diligence:-
1.     Knowledge is power
As the business literature makes clear, acquisitions are inherently risky investment decisions. One factor contributing to this risk is the acquirer’s lack of detailed knowledge about the businesses they seek to acquire. Although a general level of familiarity may exist, crucial data about targeted companies is often beyond the reach of prospective acquirers, buried in books and records, or residing in the experience of the target company’s management team.
This forces organizations to make their acquisitions dependent on assumptions about the condition and future prospects of targeted businesses; and faulty assumptions may mean the difference between success and failure[1]. Therefore, what is needed is to “take a closer look” at the transaction and what is going to be instrumental in putting you in the driver’s seat is conducting efficient due diligence on your deal or business.
2.     Safety Net:
Sources of risk vary from deal to deal. By ‘risk’, it is meant the risk that the deal will not meet the aspirations of the acquirer[2]. If the acquirer (say in an M&A deal) is well equipped with all the legal, financial and economic aspects, there is a greater chance of him meeting his aspirations. From knowing about the business, its human resources, the government policy and even environmental factors, would prepare the acquirer for any unforeseen circumstances and thereby enable him to correctly assess whether the acquisition is worth the risk. In this way, the acquirer not only makes an informed decision but is also prepared for the worst.
3.     Proper assessment as to the nature of transaction and profitability
Due diligence provides a bigger picture of the vision of the target company and its future earnings. It provides the needed clarity on the circumstantial factors surrounding the transaction. While figures and calculations lead to the prediction of a certain level of profitability, only performing due diligence can help in separating the assumptions from ground reality and provide the parties an opportunity to make an informed decision, thereby keeping the parties away from unforeseen consequences of the transaction and meeting the desired profits.
4.     Helps understand intangible & non-financial factors
There are certain aspects in a merger or acquisition which an acquirer cannot account for in monetary terms and therefore is prone to not taking them into account while entering into the transaction. These can be significant in achieving the goals and maintaining the estimated profitability of the deal. Examples can be that of the locality and the ease of the business, work habits of human resources, environmental concerns and goodwill, among many others. Conducting due diligence on these factors puts the acquirer in a much better position, to understand the practical aspect of the transaction.
5.     Accuracy of warranties and representations
While making the transaction, the seller may give all sorts of assurances and may make many claims about the business. It is the duty of the buyer to check the authenticity and veracity of such representations. Once the deal is made, there is nothing the buyer can do. There will be no seller to go after.
Therefore it is only fitting that due diligence of all parts of the seller’s business is conducted, to prevent any future mishaps. The buyer would have to check all the books of accounts and obtain all the warranties, insurances, etc. so as to absolve himself of potential liabilities. Therefore to prevent the buyer from getting drawn to the transaction, merely because the seller portrays a rosy picture of the deal, due diligence is required.
6.     Identification of deal-breaking issues and formulating business solutions to resolve them[3]
According to a study[4], around 70-80% of acquisitions fail in spite of an agreement. This is because once the parties begin due diligence, they discover certain facts about the deal which result in changing the dynamic of the transaction and makes them question the profitability or viability of the same. There can be certain issues such as pending legal disputes, or no environmental clearances, among others, which jeopardize the transaction. Due diligence points out such deal-breaking issues and gives the parties a chance to enter into consensus to mitigate the problem. It can also provide the opportunity to formulate effective business solutions to counter such problems.
7.     Prevention of frauds or illegal activities
Due diligence involves the ability to look between the lines and find something that could be illegal. Prima facie, a certain acquisition or sale may seem legitimate superficially, i.e. the acquirer may only be looking at the tip of the iceberg. Without conducting due diligence, it may not be possible to know what is fully going on below. There can be all kinds of problematic activities such as underpaying workers with no extra remuneration for extra work hours, bribing government officials, etc. Therefore, only after going through the books of accounts and other processes can the acquirer be protected of any liability towards illegal activities which he may be unaware of.

An Indian case highlighting the importance of due diligence is Daiichi’s acquisition of Ranbaxy. Daiichi, once in control by 2010, discovered that the Singh brothers made false representations to them by concealing a document known as SAR – Self Assessment Report. This document was made by a former employee and contained the true extent and impact of impending investigations by the FDA and DOJ against Ranbaxy. For Daiichi, the deal was non-value accretive. They were saddled with a difficult asset, mired in controversy with the drug regulator in their largest market[5]. The acquirer was in love with the target and therefore failed to conduct deeper legal diligence, view the FDA and DOJ investigations and the potential fallouts resulting from them.

The above-mentioned discussion clearly shows that due diligence is needed everywhere. It is required from the simplest of transactions, like buying and selling of goods, to complex mergers and acquisitions of companies.
A little effort put into the process of due diligence would go a long way in securing the reputation of the company as well as its resources and business[6]. Records have shown that the time and money spent in the due diligence process has saved many companies from financial disasters and irrevocable damage to their reputation. Due diligence can no longer be considered a luxury. Rather, in the modern-day and age, considering the ever-increasing complexity of corporate deals, it has been transformed into a necessity that is to be incorporated in almost every corporate transaction that takes place. It is a necessity which includes the compliance of legal and regulatory standards and the protection of corporate ethics and consumer loyalty.

The Due Diligence process, despite being one of the most important components of any corporate transaction, lacks a comprehensive and practical guide on the same. Through this project, the team will work towards publishing a series of research articles on Due Diligence, which will give the readers an enhanced idea about the topic. Through this series of articles, the aspects related to Due Diligence would be discussed at length, providing readers an insight into the process, the various types of due diligence, a comprehensive checklist of due diligence, and the due diligence report. Additionally, the readers would be getting an idea about the historical background of due diligence and the issues of confidentiality through Non-Disclosure Agreements and due diligence.

Mr. Anshul Ramesh (4th Year Law student, Jindal Global Law School) and Avesh Harshan (3rd year Law student, National Law University and Judicial Academy, Assam) are interns at Corp Comm Legal under Mr. Bhumesh Verma.

[1] Gole, William J, and Paul J Hilger. 2009. Due Diligence- An M&A Value Creation Approach. Wiley Finance.
[2] Howson, Peter. 2006. Commercial Due Diligence: The Key To Understanding Value In An Acquisition. Gower Publishing Limited.
[3] Mathur, Charu. 2002. "India: Legal Due Diligence". Mondaq. https://www.mondaq.com/india/Strategy/17241/Legal-Due-Diligence.
[4]Howson, Peter. 2006. Commercial Due Diligence: The Key To Understanding Value In An Acquisition. Gower Publishing Limited.
[5] Pandey, Anubhav. 2020. "8 Biggest Frauds And Mistakes In The M&A History Of India - Ipleaders". Ipleaders. https://blog.ipleaders.in/mistakes-in-the-ma-history-of-india/.
[6] "Basics Of Due Diligence" Rga-India.Com. Accessed April 5 2020. http://rga-india.com/images/basicsofduediligence.pdf.

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